Is The Market Consolidating Or Topping?

This past week I was having a discussion with my good friend Doug Short over the struggle of the S&P 500 to gain ground over the past few months. Good economic news and "stronger than expected" earnings reports have buoyed the market against the drain of liquidity from the Federal Reserve. Today, the market ripped higher at the open as hopes of a "QE" program from the ECB rippled through the markets. Despite commentary from the mainstream media that the markets are doing great, the updated chart below shows the markets continuing its tug-o-war between support and resistance.

There are two ways to look at stagnation in the markets. It is either a consolidation process that works off an overbought condition which leads to further advances, OR it is a topping process that leads to a market decline. Discerning which process is currently "in play" is critical for investor decision making. Unfortunately, as is always the case with investing, we will never know with certainty in advance. It is only in hindsight that the always bullishly biased forecasts can either be vindicated or victimized.

However, we can do some analysis to compare the current market environment with similar past markets to try an garner a "best guess" as to what might happen.

The chart below is what a consolidation process looks like. I have shown the Dow, S&P 500, Nasdaq and Russell 2000 indexes from July of 2013 through the end of last year.

Notice that the all the markets get oversold but remained in consolidation together. As the market gained strength the more “aggressive” stocks, as represented by the Nasdaq and Russell 2000, break out first followed by the more defensive large capitalization S&P 500. In other words, the degree of correlation between stocks remained high which is bullish.

The next chart shows what a topping process looks like. The consolidation pattern looks very similar to the current period as shown above. All stocks remain highly correlated and the markets get oversold prior to the next move.

The difference is that in 2011 this pattern ended in a rather severe correction of almost 20%.

The obvious question is "What was the difference?" Were there any signs that suggested that the consolidation in 2011 was going to breakdown as opposed to 2013? For that answer, we must look at some of the internal measures of the market for any tell-tale clues.

The first chart shows the percentage change in the number of stocks on bullish “buy” signals for the S&P 500 in 2011, 2013 and currently.

In 2011, the change in the number of stocks on "bullish buy signals" was deteriorating sharply and by mid-May was down 15%. This was as opposed to the consolidation process in 2013 as the change in the number of stocks rose by 20%. Notice, that during the current correction process the number of stocks on bullish buy signals has fallen by 15% at the same point as we were in 2011.

The next chart is the percentage change in the CBOE Total Put/Call Ratio. Like the VIX, the put/call ratio is a gauge of investor's “fear” of a correction in the financial markets. When investors are complacent, or lack fear, markets tend to rise. However, when this index is on the rise it is generally a sign that underpinnings of the market are more fragile.

In 2013, the markets consolidated and there was virtually no “fear” of a correction. In fact, the longer the consolidation process continued, the less fearful investors became. This was not the case prior to the onset of the correction in 2011, nor is it today.

Lastly, the NYSE High-Low Index, which measures the number of stocks hitting new highs versus new lows, is an indicator of the participation of stocks in the market. Again, I am looking at the percentage change in the number of stocks hitting highs versus lows.

In both 2011, and currently, the percentage change in the number of stocks hitting highs versus lows was virtually unchanged. This is as opposed to 2013 when new highs were accelerating over new lows as the percentage change in the index rose to nearly 90%.

There is also another important similarity between the current market environment and that in 2011. In 2011, the Federal Reserve was in the process of winding down their second liquidity program (QE2) just as they are currently. Whether continued “forward guidance” will be enough to support asset prices going forward is yet to be seen.

Let me be clear. I am not stating that the current consolidation process will absolutely collapse into a sharp correction in the months ahead. However, I am stating that the current environment is more similar to past markets which did correct, than not.

As my good friend Richard Rosso, CFP, reminded me recently:

“The markets spend 5% of their time making new highs. The other 95% of the time is spent making up prior losses.”

This is an important point to remember. While it is certainly possible that the markets could ratchet higher from here due to the "psychological momentum" that currently exists, the likelihood of a runaway bull market from here is remote. What history tells us is that when markets are attaining new highs, the end of a particular bull market cycle is closer than the beginning. It is also worthwhile to remember that getting back to even is NOT an investment strategy.

It is easy to get lured into the casino as the flashing lights and cries of barkers send out the siren's call that "everyone's a winner." However, the difference between a successful gambler and everyone else is knowing that "hot hands" eventually run cold. Knowing when to walk away from the table is what separates success from failure. In both cases, by the time a winning streak gets you back to even, it has generally run the majority of its course. As Nick Dandalos once said:

“The house doesn't beat the player. It just gives him the opportunity to beat himself. “